Tuesday, September 2, 2014

If ECB Does QE, It’s Another Sign of Western Governments’ Failures

The European Central Bank this week is expected to announce a bond-buying campaign. Recent weeks have brought a pronounced shift by the often-hawkish institution, a reversal that has been greeted enthusiastically by investors around the globe scrambling to buy government bonds.

Lost in the reports of fractional German 10-year bond yields is an unpleasant but inescapable fact: The ECB’s move underscores the abject failure of Western governments to deal meaningfully with difficult economic and demographic challenges. That abdication has left central banks such as the U.S. Federal Reserve and ECB to play an ever-larger role — one they can’t fulfill indefinitely without compromising their own integrity or the health of financial markets.

In the U.S., where a gridlocked Congress has imposed all manner of fiscal drags on growth, the Federal Reserve has similarly had to play a driver’s role. It is part of what John Llewellyn, a former Organization for Economic Cooperation and Development economist who now heads up London-based Llewellyn Consulting, describes as monetary policy’s evolution from “subservience to fiscal policy” in the 1960s to “prominence” in the inflation-wracked 1970s to becoming “the principle means of fine-tuning the economy.”

How a government taxes and spends has profound economic effect. Sound fiscal policy can add to growth, poor policy will detract from it. In the euro zone, the latter occurred in tragic fashion: The region’s unemployment rate stands at 11.5%, far higher than any industrialized country outside the zone, while youth unemployment is twice that. In Spain the jobless rate is twice the euro zone average and youth unemployment is more than twice that again – at 53.5%.

Problematically, “fiscal policy has been relegated to a budgetary matter,” Mr. Llewellyn says.

Others are more direct in their criticism of government inaction.

“There is no way other than to say that the policies have failed,” says Joseph Stiglitz, the Nobel laureate economist from Columbia University, who has calculated that euro-zone GDP is now 18% below where it would be if the 1980-2008 growth trend had continued. “They are trying to put the best face they can on this, but the numbers are much worse even than people are talking about.”

While a Cold War-like conflict brews with Russia, a key supplier of Europe’s natural gas needs, this dismal economic performance now leaves the weight of the world on Mario Draghi’s shoulders.

The ECB president’s speech at the Kansas City Fed’s Jackson Hole confab has raised talk of a Fed-like “quantitative easing” program, prompting a buying frenzy in euro-zone sovereign debt markets. But it’s now imperative, says David Kotok, chief investment officer at Cumberland Advisors, that Mr. Draghi “put his money where his mouth is.”

If he doesn’t have the political support to launch aggressive stimulus, disappointed markets will tank, businessmen will become even more pessimistic, and the region’s economies and finances will collapse, Mr. Kotok says. And he warns that Russian President Vladimir Putin could then seize on Europe’s vulnerability to impose a winter gas blockade — making Mr. Draghi an “enabler to Putin.”

That’s a tough label to pin on the one guy trying to do something. And it seems very unlikely the ECB will fail to deliver. But it’s a fair reminder of what’s at stake.

While we’re talking about inaction, let’s recap that of the governments of the European Monetary Union.

For one, they failed to provide nearly enough fiscal support to households and small businesses hit hard by the euro debt crisis. They mistakenly thought that by committing to fiscal discipline they would restore confidence and spur growth. Plunging German business expectations now expose the folly of that theory.

Governments also did too little to forge greater political unity, leaving in place the structural flaws in the monetary union that fostered the crisis.

First: the area of banking. A new European Banking Authority was created to stress-test large banks and the ECB gained more centralized oversight of bank supervision, but bank policing power was left in the hands of compromised national central banks. Portugal’s failed Banco Espirito Santo highlights that model’s flaws.

And in the continued absence of a shared deposit insurance scheme, banks in crisis countries such as Greece, Portugal and Spain have unstable sources of funding as both depositors and investors doubt the sufficiency of EU backstop funds. Facing higher costs of capital, they rein in lending.

Other failures: no agreement to issue mutualized euro-zone bonds, which would have allowed every member to borrow at the same low rate; too little done to resolve the competitiveness imbalances that left Germany supplying everyone else’s goods.

This is the hand Mr. Draghi has been dealt. Let’s hope he plays it well.